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Wage Controls Don't Work

Posted By David Weinberger On October 23, 2009 @ 10:40 am In Economics | Comments Disabled

CNBC [1] reported on Obama’s Pay Czar earlier this week:

Under the plan, which will be announced in the next few days by the Treasury Department, the seven companies that received the most assistance will have to cut the annual salaries of their 25 best-paid executives by an average of about 90 percent from last year.

As the Heritage Foundation has explained before, wage controls don’t work [2]. Policy based on envy and disdain rather than sound economics will do nothing to aid a recovery.

How does one incentivize a recovery from the most capable executives of these industries by slashing their compensation by 90 percent? What’s to stop those best capable of running these corporations from leaving and working for a company where there is no government limit on the compensation they can earn?

But even more importantly, with all the shouting and pointing at these top executives, people have forgotten about the simple fact that these payout severance packages, aka “golden parachutes,” are a beneficial function of the market.

As we’ve argued before [3], economists have identified multiple reasons that golden parachutes are beneficial. Most importantly, they incentivize the executive to make the best decision for shareholders:

First and probably most important, they reduce executives’ natural resistance to takeovers. A top executive is a leader, and typically leaders don’t like to give up their position at the top of the pecking order, especially when that position comes with prestige and perks. But sometimes a change in leadership, such as through a takeover, leaves a corporation and its shareholders better off. When a takeover is in the cards, shareholder and executive interests diverge: shareholders may stand to benefit but the executive may stand to lose his job and prestige. In this kind of situation, golden parachutes help to align the interests of executives with those of other corporate stakeholders, like shareholders and employees, by encouraging executives to make a deal, rather than doing everything possible to stay put, to the detriment of everyone else.

Second, golden parachutes encourage executives to put their talent on the market and invest in firm-specific human capital, especially in corporations and industries where changes in management are routine. A good manager can add a lot to a corporation’s bottom line, but the most skilled managers are understandably wary of giving up their current positions or industries for new ones, where things may not work out for them. In this case, golden parachutes are a sort of insurance policy against both the risk that taking a new job may work out worse than other options at their disposal and the risk that focusing on company-specific matters won’t translate into better career opportunities down the line. As a result, the market for executive talent is stronger, and executives are willing to delve more into the businesses that they run.

Executive compensation is a business matter that must be left up to the shareholders of a corporation. Wage controls from arbitrarily selected bureaucrats will not work in bringing about a recovery, or fixing the system.

David Weinberger currently is a member of the Young Leaders Program at the Heritage Foundation. His views do not necessarily reflect the views of the Foundation. For more information on interning at Heritage, please visit: http://www.heritage.org/about/departments/ylp.cfm [4]


Article printed from The Foundry: Conservative Policy News from The Heritage Foundation: http://blog.heritage.org

URL to article: http://blog.heritage.org/2009/10/23/wage-controls-dont-work/

URLs in this post:

[1] CNBC: http://www.cnbc.com/id/33417281#

[2] don’t work : http://www.heritage.org/Research/Regulation/wm2570.cfm

[3] we’ve argued before: http://www.foundry.org/2009/02/04/unintended-consequences-on-executive-pay-i-golden-parachutes/#

[4] http://www.heritage.org/about/departments/ylp.cfm : http://www.heritage.org/about/departments/ylp.cfm

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